Corporate Finance

CHAPTER 13
RETURN, RISK, AND THE SECURITY MARKET LINE
Copyright © 2022 McGraw Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill.
LEARNING OBJECTIVES
• Show how to calculate expected returns, variance, and

standard deviation
• Discuss the impact of diversification
• Summarize the systematic risk principle
• Describe the security market line and the risk-return trade-

off
13-2
CHAPTER OUTLINE
• Expected Returns and Variances

• Portfolios
• Announcements, Surprises, and Expected Returns
• Risk: Systematic and Unsystematic
• Diversification and Portfolio Risk
• Systematic Risk and Beta
• The Security Market Line
• The SML and the Cost of Capital: A Preview
13-3
EXPECTED RETURN
• Consider a single period of time—say a year. We have two stocks, L
and U, which have the following characteristics:
• Stock L is expected to have a return of 25% in the coming year
• Stock U is expected to have a return of 20% for the same period
• There are two states of the economy, which means that there are
only two possible situations, and the two are equally likely to occur:
• Economy booms, in which case Stock L will have a 70% return and
Stock U will have a 10% return
• Economy enters a recession, where Stock L will have a -20% return
and Stock U will have a 30% return
• Expected return is the return on a risky asset expected in the future

13-4
EXPECTED RETURN
(CONTINUED)
• Expected return on Stock U, E(RU), is 20%, found by:
• E(RU) = .50 × 30% + .50 × 10% = 20%
• Expected return on Stock L, E(RL), is 25%, found by:
• E(RL) = .50 × −20% + .50 × 70% = 25%
• The following table illustrates these calculations:
13-5
EXPECTED RETURN
(CONCLUDED)
• Using projected returns, we can calculate the projected, or expected,
risk premium as the difference between the expected return on a
risky investment and the certain return on a risk-free investment
• Suppose risk-free investments are currently offering 8% (i.e., the
risk-free rate, which we label as Rf , is 8%). Given this, what is the
projected risk premium on Stock U? On Stock L?
• Expected return on Stock U, E(RU), is 20%; projected risk premium is:
• Risk premium on Stock L is 25% - 8% = 17%

• In general, the expected return on a security or other asset is equal
to the sum of the possible returns multiplied by their probabilities
13-6
UNEQUAL PROBABILITIES
13-7
CALCULATING THE VARIANCE
• Let us return to the Stock U, which has an expected return of E(RU)
= 20%. In a given year, it will actually return either 30% or 10%.
• Possible deviations are 30% − 20% = 10% and 10% − 20% = −10%
• In this case, the variance is:
• Variance = σ2 = .50 × .102 + .50 × (−.10)2 = .01
• The standard deviation is the square root of this:
• Standard deviation = σ = = .10, or 10%
13-8
CALCULATING THE VARIANCE
(CONTINUED)
• The way we have calculated expected returns and variances here is
somewhat different from the way we did it in the last chapter
• If examining actual historical returns, we estimate the average return
and the variance based on some actual events
• Here, we have projected future returns and their associated
probabilities, so this is the information with which we must work
13-9
MORE UNEQUAL PROBABILITIES
13-10
PORTFOLIOS
• A portfolio is a group of assets such as stocks and bonds held by an
investor
• Portfolio weights are percentages of a portfolio’s total value

invested in a particular asset
• If we have $50 in one asset and $150 in another, our total portfolio
is worth $200
• Percentage of our portfolio in the first asset is $50/$200 = .25.
• Percentage of our portfolio in the second asset is $150/$200 = .75
• Our portfolio weights are .25 and .75
13-11
PORTFOLIO EXPECTED RETURNS
• Let’s go back to Stocks L and U. You put half your money in each.
What is the pattern of returns on this portfolio? Expected return?
• Suppose the economy enters a recession, in which case half your
money (the half in L) loses 20% and the other half (the half in U) gains
30%
• In a recession, portfolio return is: RP = .50 × −20% + .50 × 30% = 5%
• In a boom, portfolio return is: RP = .50 × 70% + .50 × 10% = 40%
• Thus, expected return on your portfolio, E(RP), is 22.5%
• We can calculate the expected return more directly:
E(RP) = .50 × E(RL) + .50 × E(RU)
= .50 × 25% + .50 × 20%
= 22.5%
• If we have n assets in our portfolio, where n is any number, and xi
stands for the percentage of our money in Asset i, expected return is:
13-12
PORTFOLIO EXPECTED RETURN
13-13
PORTFOLIO VARIANCE
• Variance on a portfolio is not generally a simple combination of the
variances of the assets in the portfolio
• What is the standard deviation of returns on the portfolio?
• Suppose we put 2/11 (about 18%) in L and the other 9/11 (about
82%) in U. If a recession occurs, this portfolio will have a return of:
• RP = (2/11) × −20% + (9/11) × 30% = 20.91%
• If a boom occurs, this portfolio will have a return of:
• RP = (2/11) × 70% + (9/11) × 10% = 20.91%
• Clearly, this portfolio would have a zero variance 13-14
PORTFOLIO VARIANCE AND
STANDARD DEVIATION
13-15
EXPECTED AND UNEXPECTED RETURNS
• Consider the return on the stock of a company called Flyers. What
will determine this stock’s return in, say, the coming year?
• Return on stock traded in financial market is made up of two parts:
1. The normal, or expected, return from the stock is the part of the
return that shareholders in the market predict or expect
2. The uncertain, or risky, part is the portion that comes from
unexpected information revealed within the year
• Return on Flyers stock in the coming year would be:
• R stands for the actual total return in the year

• E(R) stands for the expected part of the return
• U stands for the unexpected part of the return
13-16
ANNOUNCEMENTS AND NEWS
• Suppose Flyers’s business is such that the company prospers when
GDP grows at a relatively high rate and suffers when GDP is
relatively stagnant. When the government actually announces GDP
figures for the year, what will happen to the value of Flyers’s stock?
• Answer depends on what figure is released
• Answer also depends on what shareholders forecast GDP to be
• Suppose shareholders forecast GDP to increase by 0.5%, but the
government announces that the actual GDP increase during the
year has been 1.5%
• Difference between actual result and forecast, 1% in this example,
is sometimes called the innovation or the surprise
• An announcement can be broken into two parts: the anticipated,
or expected, part and the surprise, or innovation:
13-17
SYSTEMATIC AND UNSYSTEMATIC RISK
• Systematic risk (i.e., market risk) influences many assets (e.g.,
uncertainties about general economic conditions, such as GDP, interest
rates, or inflation)
• Unsystematic risk (i.e., unique or asset-specific risk) is a risk that affects
at most a small number of assets (e.g., the announcement of an oil
strike by a company)
• Actual return broken down into its expected and surprise components:
R = E(R) + U
• Total surprise component has systematic and unsystematic component:
• We can rewrite the formula for the total return, allowing ϵ to stand for
the unsystematic portion and m to stand for the systematic part:
R = E(R) + U
= E(R) + m + ϵ 13-18
EFFECT OF DIVERSIFICATION: ANOTHER
LESSON FROM MARKET HISTORY
• Table 13.7 illustrates typical
average annual standard
deviations for equally weighted
portfolios that contain different
numbers of randomly selected
NYSE securities
• Standard deviation for
“portfolio” of one security is
49%, meaning if you randomly
selected a single NYSE stock
and put all your money into it,
your standard deviation of
return would typically be a
substantial 49% per year
• Note the standard deviation
declines as the number of
securities is increased 13-19
THE PRINCIPLE OF DIVERSIFICATION
• Figure 13.1 plots the standard
deviation of return versus the
number of stocks in the
portfolio
• Notice the benefit in terms of
risk reduction from adding
securities drops off as we add
more and more
• Key points:
• Principle of diversification
implies some of the riskiness
with individual assets can be
eliminated by forming
portfolios
• There is a minimum level of
risk that cannot be eliminated
by diversifying (i.e.,
nondiversifiable risk) 13-20
DIVERSIFICATION AND
UNSYSTEMATIC RISK
• Some of the risk associated with individual assets can be
diversified away and some cannot. Why is this so?
• If we held only a single stock, the value of our investment would
fluctuate because of company-specific events
• If we hold a large portfolio, some of the stocks in the portfolio will
go up in value because of positive company-specific events and
some will go down in value because of negative events
• Net effect on the overall value of the portfolio will be relatively
small because these effects will tend to cancel each other out
• When we combine assets into portfolios, the unique, or
unsystematic, events—both positive and negative—tend to “wash
out” once we have more than just a few assets
13-21
DIVERSIFICATION AND
SYSTEMATIC RISK
• If unsystematic risk can be eliminated by diversification, is the
same true for systematic risk?
• No, a systematic risk affects almost all assets to some degree, so no
matter how many assets we put into a portfolio, the systematic risk
doesn’t go away
• The total risk of an investment, as measured by the standard

deviation of its return, can be written as:
• Systematic risk is also called nondiversifiable risk or market risk

• Unsystematic risk is also called diversifiable risk, unique risk, or
asset-specific risk
13-22
THE SYSTEMATIC RISK PRINCIPLE
• Systematic risk principle states the expected return on a risky
asset depends only on that asset’s systematic risk
• Only the systematic portion of total risk is relevant in determining
the expected return (and the risk premium) on that asset
• Level of systematic risk is measured using the beta coefficient, β
• An average asset has a beta of 1.0 relative to itself; an asset with a
beta of .50 has half as much systematic risk as an average asset; an
asset with a beta of 2.0 has twice as much
13-23
TOTAL RISK VERSUS BETA
13-24
PORTFOLIO BETAS
• A portfolio beta can be calculated just like a portfolio expected
return
• If we had many assets in a portfolio, we would multiply each asset’s
beta by its portfolio weight and then add the results to get the
portfolio’s beta
• Using Table 13.8, suppose you put half of your money in Shopify and
half in Coca-Cola. What would the beta of this combination be?
• Because Shopify has a beta of 1.59 and Coca-Cola has a beta of .55,
the portfolio’s beta, βP, would be:
βP = .50 × βShopify + .50 × βCoca-Cola = .50 × 1.59 + .50 × .55 = 1.07
13-25
PORTFOLIO
BETAS:
AN
EXAMPLE
13-26
BETA AND THE RISK PREMIUM
• Suppose Asset A has an expected return of E(RA) = 20% and a beta of
βA = 1.6. Furthermore, suppose that the risk-free rate is Rf = 8%.
• Consider a portfolio made up of Asset A and a risk-free asset. If 25%
of the portfolio is invested in Asset A, then the expected return is:
E(RP) = .25 × E(RA) + (1 − .25) × Rf
= .25 × 20 % + .75 × 8%
= 11%
• The beta on the portfolio, βP, would be:

βP = .25 × βA + (1 − .25) × 0
= .25 × 1.6
= .40
13-27
(CONTINUED)
• Is it possible for the percentage invested in Asset A to exceed 100%?
• Yes, this happens if the investor borrows at the risk-free rate
• Suppose an investor has $100 and borrows an additional $50 at 8
percent, the risk-free rate. The total investment in Asset A would be
$150, or 150 percent of the investor’s wealth.
• The expected return in this case would be:
E(RP) = 1.50 × E(RA) + (1 − 1.50) × Rf
= 1.50 × 20% − .50 × 8%
= 26%
• The beta on the portfolio would be:
βP = 1.50 × βA + (1 − 1.50) × 0
= 1.50 × 1.6
= 2.4
13-28
(CONCLUDED)
• Other possibilities for Asset A may be calculated as follows:
13-29
THE REWARD-TO-RISK RATIO
• Expected returns from the
previous slide are plotted
against portfolio betas in the
graph below
• Notice all combination fall on a
straight line. What is the slope
of the straight line?
• Slope of line is risk premium on
Asset A, E(RA) − Rf , divided by
Asset A’s beta, βA:
13-30
THE BASIC ARGUMENT
• Suppose we consider a second asset, Asset B. This asset has a beta
of 1.2 and an expected return of 16%. Which investment is better,
Asset A or Asset B?
• To begin, calculate different combinations of expected returns and
betas for portfolios of Asset B and a risk-free asset, just as we did for
Asset A
• For example, if we put 25% in Asset B and the remaining 75% in the
risk-free asset, the portfolio’s expected return will be:
E(RP) = .25 × E(RB) + (1 − .25) × Rf
= .25 × 16 % + .75 × 8%
= 10%
• Similarly, the beta on the portfolio, βP, will be:
βP = .25 × βB + (1 − .25) × 0
= .25 × 1.2
= .30
13-31
THE BASIC ARGUMENT
(CONTINUED)
• Other possibilities for Asset B may be calculated as follows:
• Plotting these combinations results in a straight line, as with Asset A:
13-32
THE BASIC ARGUMENT
(CONCLUDED)
• The figure below compares the results for Assets A and B
• Note the line describing the combinations of expected returns and
betas for Asset A is higher than the one for Asset B
• Implies that for any given level of systematic risk (as measured by β),
some combination of Asset A and the risk-free asset always offers a
larger return
13-33
THE FUNDAMENTAL RESULT
• Situation we have described for Assets A and B could not persist in a
well-organized, active market, because investors would be attracted
to Asset A and away from Asset B
• Asset A’s price would rise and Asset B’s price would fall
• Because prices and returns move in opposite directions, A’s expected
return would decline and B’s would rise
• Buying and selling would continue until the two assets plotted on
exactly the same line, which means they would offer the same
reward for bearing risk
• In an active, competitive market, we must have the situation that:
• No matter how many assets we have, the reward-to-risk ratio must

be the same for all assets in the market
13-34
BUY LOW, SELL HIGH
13-35
THE SECURITY MARKET LINE
• The security market line (SML) is a positively sloped, straight line
displaying the relationship between expected return and beta
• Suppose we consider a portfolio made up of all the assets in the
market (i.e., a market portfolio), with the expected return on this
market portfolio denoted as E(RM)
• Because all the assets in the market must plot on the SML, so must a
market portfolio made up of those assets
• Because the market portfolio is representative of all assets in the
market, it must have average systematic risk (i.e., a beta of 1)
• We could express the slope of the SML as:
• Market risk premium is the slope of the SML, the term E(RM) - Rf
13-36
THE CAPITAL ASSET PRICING MODEL
• Capital asset pricing model (CAPM) is the equation of the SML
showing the relationship between expected return and beta
• Let E(Ri) and βi stand for the expected return and beta, respectively,
on any asset in the market, and the following equation is the CAPM:
• CAPM shows the expected return for a particular asset depends on

three things:
1. Pure time value of money: As measured by risk-free rate, Rf, this is
the reward for waiting for your money, without taking any risk
2. Reward for bearing systematic risk: As measured by the market
risk premium, E(RM) − Rf, this is the reward offered for bearing an
average amount of systematic risk in addition to waiting
3. Amount of systematic risk: As measured by βi, this is the amount
of systematic risk present in a particular asset or portfolio, relative
to that in an average asset
13-37
THE CAPITAL ASSET PRICING MODEL
(CONTINUED)
13-38
RISK AND RETURN
13-39
SUMMARY OF RISK
AND RETURN
13-40
THE SML AND THE COST OF CAPITAL:
A PREVIEW
• Security market line tells us the reward for bearing risk in financial
markets
• Only way to benefit our shareholders is by finding investments with
expected returns that are superior to what the financial markets
offer for the same risk; such an investment will have a positive NPV
• To determine whether an investment has a positive NPV, we
compare the expected return on that new investment to what the
financial market offers on an investment with the same beta
• Appropriate discount rate on a new project is the minimum

expected rate of return an investment must offer to be attractive
(i.e., the cost of capital)
• By saying an investment is attractive if its expected return exceeds
what is offered in financial markets for investments of the same risk,
we are effectively using the internal rate of return (IRR) criterion
13-41
SELECTED CONCEPT QUESTIONS
• How do we calculate the expected return on a security?
• Is there a simple relationship between the standard deviation on a
portfolio and the standard deviations of the assets in the portfolio?
• What are the two basic parts of a return?
• What is the distinction between the two types of risk?
• What happens to the standard deviation of return for a portfolio if
we increase the number of securities in the portfolio?
• True or false: The expected return on a risky asset depends on that
asset’s total risk. Explain.
• What is the security market line? Why must all assets plot directly
on the SML in a well-functioning market?
• If an investment has a positive NPV, would it plot above or below
the SML? Why? 13-42
END OF CHAPTER
CHAPTER 13
13-43

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CHAPTER 13

RETURN, RISK, AND THE SECURITY MARKET LINE

• Show how to calculate expected returns, variance, and

• Discuss the impact of diversification

• Summarize the systematic risk principle

• Describe the security market line and the risk-return trade-

• Expected Returns and Variances

• Expected return is the return on a risky asset expected in the future

• The following table illustrates these calculations:

• Risk premium on Stock L is 25% - 8% = 17%

• Portfolio weights are percentages of a portfolio’s total value

• Return on Flyers stock in the coming year would be:

• R stands for the actual total return in the year

• The total risk of an investment, as measured by the standard

• Systematic risk is also called nondiversifiable risk or market risk

• The beta on the portfolio, βP, would be:

• Other possibilities for Asset A may be calculated as follows:

• Plotting these combinations results in a straight line, as with Asset A:

• No matter how many assets we have, the reward-to-risk ratio must

• CAPM shows the expected return for a particular asset depends on

• Appropriate discount rate on a new project is the minimum

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